Printable ViewEmail this PageTuesday, October 17, 2006
In 1966, I was traveling the Pacific aboard a freighter. I was 19 years old at the time and attending the U.S. Merchant Marine Academy at Kings Point, N.Y.

As part of my academy education, I spent a year as a student officer on freighters, passenger liners, oil tankers, and even tugboats. It was a great way to see and study the world.

An Instructive Exchange

One of the earliest lessons I learned at sea was about currency exchange rates. Even though currency valuation was not a subject taught at the Merchant Marine academy, my ship constantly traveled from one country to the next, so my education in what is today called FX -- or foreign exchange -- began.

Back then, the formal exchange rate in the banks was 360 Japanese yen to one U.S. dollar. On the black market in Hong Kong, I could get 366 yen to the dollar.

This made me aware of the games banks and countries play with their currencies: In 1966, the six-yen difference told me that Japan was buying more from Hong Kong, which is why yen was cheaper in the then-British colony.

A six-yen difference might not seem like much, but for a student earning just $105 a month every little bit counts. So I would wait for my ship to stop in Hong Kong and then trade U.S. dollars for yen. Then I would travel back to Japan and go shopping with the yen. Although the money I saved wasn't substantial, the lessons it offered in currency exchange were priceless.

The End of the Golden Age

It was pretty easy to understand foreign exchange back in the mid-â€˜60s, since much of the world was following the Bretton Woods Agreement. Enacted in 1944, this agreement made the U.S. dollar the global medium of exchange.

Because the U.S. dollar was pegged to gold, figuring exchange rates was a cinch. If we purchased too much from Japan, then the Japanese could ask us for gold. If we had less gold, we had less money.

In 1971, President Richard Nixon changed everything by removing the U.S. dollar from the gold standard. Suddenly, the dollar was still the world's currency, but now it was backed by nothing. The United States was free to print as much money as it wanted, and the world went along.

Because of this change, understanding foreign exchange became a bit more complex. Today, to understand the world of currency, you need to think a little differently -- essentially because things don't make sense.

For example, today, the United States is perceived to be the richest country in the world. In reality, though, we're the biggest debtor nation in the world. And who are we indebted to? What many consider to be a Third World country: China.

For Richer and Poorer

The irony is that many Americans think we're rich and China is poor. Exactly the opposite is true. This is because the removal of gold's backing from paper money has created a virtual explosion in credit and liquidity. The sheer amount of liquidity around the globe is incalculable.

This excess funny money causes people to feel rich and almost everything to be more expensive. Today, stocks, real estate, automobiles, and gasoline become more expensive as the dollar becomes cheaper.

While some people do become richer in this system, funny money actually punishes working people who save money. It devalues the value of your work and your savings, even though you may feel wealthier.

In overly simplistic terms, China and many countries in the world today lend us billions of dollars to buy their goods. They send us products like computers, televisions, cars, candies, and wines, and we send them funny money in return.

Since they can't spend those dollars at home, they simply lend them back to us so we'll buy more of their products. That would be like me going to my local grocery store and asking them for a loan so I could buy their tomatoes. A logical person would say, "That makes no sense." Yet it's exactly what happened after 1971, and to many highly educated people -- bankers and politicians, for instance -- it somehow does make sense.

An Uneven Trade

You can find current smaller examples of such financial insanity. For example, many people refinance their homes to pay off their credit cards. This makes no sense; you and I know that someday that debt will have to be paid.

Yet getting deeper into debt does make sense as long as you can repay your lender with cheaper dollars, and as long as your lender is willing to take those cheaper, less-valuable dollars. To use my earlier analogy, it would be like buying an orange for $1 on credit and then paying him back for it a year later with 80 cents. As long as the grocer is happy with this arrangement, things are fine.

In real-world terms, one of the reasons the U.S. dollar only buys approximately 110 yen instead of 360 yen today is because the Japanese allowed us to continually devalue the dollar -- that is, to pay our debts with cheaper dollars.

Over the years, the yen got stronger and the dollar got weaker simply because we, as a nation, printed more and more money, all the while consuming more and producing less. Japan would lend us money and we would buy their products. Japan's economy boomed, and so did ours.

Game Over?

The problem today is that China isn't willing to play the game the way the Japanese did. If we drop the purchasing power of the dollar, the Chinese, by pegging their currency to the dollar, also drop the value of their currency. The United States then pays back its debt with a cheaper dollar.

The irony is that we accuse China of playing games with their money. It's more honest to say that China just isn't willing to play the game we want to play.

But an even bigger problem is looming: It seems like the rest of the world is less willing to play our money game. That's why the European Union introduced the Euro. If China creates an Asian equivalent of the Euro (which, admittedly, is a long shot) then the U.S. dollar could be in real trouble.

If the oil-producing nations stop accepting the dollar and switch to gold or the Euro, things will definitely get sticky. The world might be tipped into a global recession and possibly even a depression.

For now, though, this funny money game continues. How long will it last? I don't know. I do know that throughout history, all paper money has eventually come back to its true value, which is zero. That's when the game truly ends, and a whole new cycle of pass the buck begins.